Banc of California, Inc. (NYSE:BANC) has completed its merger into PacWest (PACW) and received an investor injection of $400 million in the process. PacWest will take the name “Banc of California” and the related ticker, so that name will survive. The combined situation will begin as a higher-risk situation. But the combined bank has a plan to reposition the organization on an investment grade type pathway in the future that would be far less risky. For those who can handle the risk of a bank turnaround situation, the current bank stock price could easily lead to a decent dividend yield based upon an expected total recovery.

The Main Strategy

Turnaround situations that are successful often yield a decent dividend when the turnaround is successful. Because turnaround times can vary and have different risk levels during that process, it is often best for an idea like this one to be part of a basket rather than loading up on an idea or two.

A well-chosen basket should do ok even if one or two turnarounds do not succeed as planned or worse happens.

This is directed at either income investors who have some funds that can withstand an idea like this as opposed to living on all the income a stock portfolio generates. Or it can also be used by someone retiring in the future who does not need the income right now.

For a long time, any bank that the Federal Reserve chose to “save” or merge was fairly close to a “sure thing” investment (as you could get) in the stock market.

The rules have changed in the Internet age, as some websites have continued to attack banks that the Federal Reserve tried to save with the resulting panic leading either to mergers or bank failures. The Federal Reserve basically fumbled around this last time when this new situation arose. But it is highly likely that by the next time bank failures are on the horizon in decent numbers, the Federal Reserve will have a workable strategy in place.

The Bank Strategy

Back when the merger was announced, the bank posted the following post-closing strategy:

There has been some statements about this since then and there are likely to be far more. Any changes that really matter are likely to be made after the combination closes and the fully combined bank is both examined and run as a single entity. However, the main idea of setting the combined entity firmly on the path to recovery has not changed. Probably the material update will be the next earnings report, which is due early next year.

Otherwise, there may be some amount changes as time goes on and maybe a switch in a step or two shown above. None of that is likely to indicate a change in the end result.

What has changed is the interest rate environment. Back in March, when this was first announced, we were all praying that the interest rate rises would stop. Now it not only looks like there will not be any more Federal hikes (or maybe one or two at most), but it also appears that the yield curve has a good possibility of sustaining an inversion that would eventually put pressure on the Federal Reserve to decrease interest rates.

A lot of transactions take place with an eye on the future. A lower interest rate outlook raises the chances of a successful transaction along the lines shown above with likely lower losses than anticipated when the original deal was made. This is actually one of the advantages of these turnarounds in that there is plenty of time after the market bottoms to invest and make a decent profit.

One of the things not really discussed is the ideal “equity cushion” that should be part of this once the merger completes. There is talk about a mandatory equity of 10% in the future by regulators. Should that rule become firm, it may take a little longer for dividends to get where the market expects dividends to be for this bank.

Of course, along with that “mandatory” equity, there would likely be as much as another 2% equity cushion. Clearly, the combined bank begins in far better shape than was the case for the two banks as standalone units. The ideal end result may have to be flexible with upcoming (potential) regulator decisions.

The $400 million that will improve the equity component (and is part of the merger agreement) is from Warburg Pincus, who will also have a board seat. While this does not guarantee success, it does count as a vote for the success of this venture from a professional that may know more than the average investor.

Latest Earnings Reports

Mostly the latest earnings reports serve as a final check that the merger assumptions are still reasonable and that the assets are “intact as planned.” There is not much else to really take from the reports because the combined entity is going to reposition the portfolio of the combined bank, which in and of itself is a material change. All that is really needed before the closing is a check to make sure that nothing material has happened that would threaten the success of the merger. Even if the investor missed something like this, the stock price would indicate Mr. Market is worried about the merger enough to have the investor consider a second look (just in case).

Key Ideas

Banking turnaround situations often have one of the better records of succeeding because there is active input from a number of sources besides the bank that is considered troubled. There are also more checks and balances along the way to make sure those considerations have not materially changed in the meantime.

Such turnarounds are often fertile ground for an investor considering retirement in the 5-to-10-year range (give or take) because the money invested in a well-chosen basket of these cases can often have a future dividend yield that is well above average. In the best case, the bank chooses to grow in the future which leads to a rising dividend yield.

The stock price often grows as well so that if the dividend fails to meet a retiree’s requirements in the future, there is often more principal to invest to get that desired return elsewhere.

This is an idea that could attract any dividend investor that does not need the dividend right now but will in the future as well as any investor interested in a turnaround situation. The idea would be to make a basket of a variety of banks with recovery potential. Even risk averse investors can often consider that type of turnaround due to the regulatory supervision that often occurs with this situation.

In the meantime, the recovery potential of the combined entity should result in a far higher stock price in 5 years than is the case right now. Most bank stocks need to double (at least) to get back to former valuations. There is never a guarantee that will happen. However, decent managements often work towards a recovery that equals the previous stock price high (roughly) plus inflation. For an analysis, it is a reasonable place to begin. Based upon the evaluation of management and combined bank actual management, the investor can decide a future stock price target.

Should management decide upon a conservative growth strategy, the stock could go higher. Making a well-chosen basket of situations like this should reduce the risk of total (or really any) failure.